Japan - Engine Failure

By Claus Vistesen: Copenhagen

Last time I had Japan under the loop I asked whether there was no end in sight for Japan's economy and as I wind up for another close look, I must say that it is still very difficult to find good news if any at all. However, and for the sake of argument I thought that we might begin with some recent arguments in the context of the global economy which suggest that we may be past the worst of our travails. The first observation comes from the Economist's ever eloquent financial markets pundit, Buttonwood, who recently made the neat point that while we are still stuck in the mire, the second derivative might be turning positive. This suggests that while indicators are still on the decline they are now declining less rapidly. In Tokyo, Cassandra voices a similar sentiment as she takes stock of the number presented earlier last week by the Asian Development Bank that as much as USD 50 trillion, so far, has vanished into thin air during this crisis. Hovering between the "half full, half empty" metaphor Cass notes;

For the moment, I'll take the middle ground and venture that having shed an awful lot of aggregate value (an entire year of global GDP according to the ADB!), we're a lot closer to where we're going than we were.

It may come to a surprise to my readers given the traditional very bearish sentiment expressed at this space, but I actually agree with Buttonwood and Cassandra here. However, I would simply add the important qualifier that there will be a significant asymmetry in terms of where individual economies are going as a function of where they are and were. No where is this more true in the case of Japan and as we progress to the data and analysis it should be abundantly clear that for all the talk of second derivatives and glasses being half full, Japan still look to be in an extraordinarily bad shape. Initial evidence of this comes from the headline GDP figures which don't seem to be blessed with any second derivative effects.

Final estimates from Q4 2008 suggested that Japan contracted at an annualized 12.1% which puts Japan in the dubious pole position of biggest GDP declines among industrialised economies. Q1 estimates are yet to be released, but no-one expects, I think, an improvement as the incoming data so far has been nothing but extraordinarily poor. Sociétè Generale expects Japan to contract sharply in 2009 with Q1 as an forecast bottom. I am not sure about the bottom in the sense that while it may be a bottom in the sense of the second derivative noted above, it won't likely mark a return to sustained growth.

In this note, I will provide an overview of the recent developments in the Japanese economy. Since we last convened some interesting points have emerged. For one, Japan is back in deflation measured on the US style core price index and for the first time in a very long time Japan is now running a current account deficit. This last point will be studied in some detail since it marks a very important issue for the export dependent Japanese economy both in a historical and a current perspective. Before we begin I should note that this post is very big with a lot of graphs and even an econometric model to boot. I understand full well if this deters some of my readers; I shall not hold it against you.

Prices and Consumption, where art thou?

If there is one thing which has been stable in Japan throughout this crisis it has been the persistent sluggish trend in domestic demand measured by top line household consumption expenditures as well as prices on the other hand. These two data points consequently tell an important part of the story of the lack of domestic demand in Japan or more specifically the lack of visible momentum to pull Japan out of the doldrums. One persistent feature of the initial phases of the crisis where markets and global policy makers primarily looked towards the risk of stagflation was that inflation in Japan exclusively was driven by cost-push factors in the form of headline inflation and not demand pull factors. This idea is a well established one at this point, and materialised itself in the fact that as headline inflation shot through the roof core inflation only budged slightly. It is important to point out that this inelasticity cuts both ways and as headline inflation has abated (for now), so has the spread between the two indices narrowed significantly. The underlying point here is thus two-fold. One the one hand it is dangerous to assume that inflation driven by domestic demand conditions will correlate with external headline inflation pressures which, due to global capacity constraints and global demand conditions, look set to shoot higher the minute we move even slightly beyond the current malaise. On the other hand however, we can clearly see, in Japan, that whatever trend we see for headline inflation domestically induced price pressures in Japan are virtually non-existing and now that the crisis is seriously biting Japan is set once again to retrench into deflation despite the central bank's most ardent efforts to apply measures of quantitative easing.

As I have argued before, I believe a large part of Japan's problem with deflation is demographic. In particular, I think that because Japan is basically unable to achieve growth based on domestic momentum a growth scenario strictly based on domestic activity as the one we are seeing at the moment will be de-facto deflationary. However, since Japan is largely dependent on energy imports in so far as goes its consumption of fossil fuels (i.e. a high passthrough effect) the overall inflation indice will diverge from the core of core index which, in Japan's case, is a good proxy for domestically induced price pressures. Now, I realize that my readers will be skeptical of the demographic link here, but let me at least present results that show the broken link between the general price index and core of core prices (which exclude energy and food). Thanks to a novel data set from Japan' statistical office giving us monthly inflation rates (y-o-y) for all three recorded inflation indices since 1971 we have plenty of ammunition on our hands to proceed. In the following all numbers will be based on de-trended time series which in this case simply means that I am using the first difference.

Consider then the very simple representation below which shows the correlation between the general index and core of core index over the entire sample, from 1971-1996 and from 1997-2008.

The emerging picture should be quite straightforward to interpret even for the untrained eye. Consequently, and in so far as we can consider the simple correlation coefficient a credible measure of the strenght of the connection between two variables, then this relationship has clearly deteriorated. In graphical terms we can get an impression of this by looking at the three year rolling average of the correlation between the variables.

Now, the volatility is considerable here and in fact we can see that the correlation has hit rock bottom once before , but the accumulated trend is still one of a decline in relationship between the two variables. If we want to be even more specific we can express this in the form of single linear regression where we let the general inflation index explain the core-of-core index. As is visible below, this also shows a marked decline in explanatory relationship. However, this may not be an adequate conceptualization of the issue at hand. Consequently, let us try to narrate the problem as one of headline inflation leading core-of-core inflation. This potentially brings us into the deep murky vaults of time series econometrics and I shall not belabour my readers with techniques on how to choose optimal lags here (I tried with both a quarterly and monthly). What we end up with is the following small model.

The fit is not perfect and in terms of actual prediction tool I would be weary in using this expression alone although in a standard ARMA framework one could perhaps play around with the lags of other variables. Yet, the picture is now firmly solidified as we observe a secular decline in the model's ability to model the core-of core index.

So, what the heck is this all for then? Clearly, it is difficult to show initially that demographics represent an important underlying explanatory variable in this framework. Yet, it does corresponds with the overall point expressed above that when domestic demand is unable to generate inflation exogenous energy shocks won't necessarily lead to underlying inflation dynamics. On a general note, it is thus difficult to see how Japan can avoid to enter a serious bout of deflation during the course of 2009 especially since, at this point, deflation is being pencilled in across a wide batch of economies across the globe. As will be showed below the BOJ is already coming up with ever more spectacular measures to ward off a lingering fall into deflation. There are two forward looking issues to watch out for when it comes to the comeback of deflation in Japan. One is the point that since everybody is facing deflation, and thus engaging in different forms of QE will Japan then be less of an odd man out? A second a highly related point is what will happen to the JPY in relation to the whole collective edifice of QE among OECD central banks?

Turning briefly to the consumption expenditures and thus the state of the Japanese consumer it really is (un)steady as she goes. Some analysts have expressed the opinion that the Japanese consumer has held up alright up until this point in the crisis. I am not sure what data these analysts are looking at. All I know is that the headline figure for consumption expenditures is still clocking in one negative number after the other and in this light it is difficult to see from where the much awaited boost in domestic demand is going to come from; note for example here that autosales dropped a healthy 27.9% in January. Add to this that retail sales dropped 5.8% on an annual basis with the subcomponent and you have firm evidence of a slump.

To be fair, the latest reading on consumer confidence did show an uptick in February compared to January as well as the economy watchers index which measures the performance of non tradables showed an improvement, but the accompanying comments from analysts on the ground do not provide much comfort for the outlook where most domestic companies are preparing their operations for a tough recession. Ken Worsley parses the entrails of the consumer confidence report and notes that the slight increase in the willingness to buy consumer durables is a welcome sign although the overall picture is weighed down by a mounting insecurity over job safety and thus income.

Investment, huddling up for hibernation?

If the charts for consumer spending shows us that the Japanese consumer is performing decidedly worse than past years' mean, the corresponding charts and numbers of industrial production and industrial orders resemble clear depression tendencies.

It is important to note the difference between the plots above. Consequently, what we are seeing in Japan at the moment is especially a massive slump in manufacturing and industrial production dragged down by the sharp drop in external demand. In this way, the export sector so important for Japan's growth is inexorably tied together with industrial production. In the last post the graph did not include Q4 2008 and as is readily clear from the charts above Q4 08 was the breaking point for Japan (and most others too).

This picture is confirmed if we look at the monthly reading. Since the data graphed above is from the METI, the data is lacking relatively to the present in that we only have data up until January 2009 (for the monthly chart). However, just look at that line go as if it is being pulled down by gravity itself. Needless to say that the overall index is being dragged down here even if the tertiary index, which accounts for 3 times as much as industrial production in the overall index, is holding up quite well. On an annual basis, industrial production dropped a full 31% in terms of production and 31.6% in terms of shipments. Inventories decreased on a monthly basis, but are still well above their 2000 levels which makes me wonder what kind of information the analysts claiming that Japanese companies had comparatively low inventories going into this were looking at. As for the small bounce in tertiary industry postal services seem to be the main culprit increasing with a full 11%.

As for the link between manufacturing and exports, I am going to let Danske Bank's analysts do the heavy lifting and display their wonderful graph plotting industrial production and exports.

I don't think this requires much interpretation and the main points is well articulated by Danske;

In Japan, manufacturing accounts for about 22% of GDP compared with just 17% and 12% of GDP in Euroland and the US, respectively. For that reason, there is a larger negative secondary impact on particularly investment demand from the recent collapse in global trade and industrial production.

The outlook here is thus completely dependent on where you think global growth is heading. Given the increasing indications that the slump will be prolonged the outlook is bleak. Of course, and coming back to that dreaded second derivative the decline will stabilise at some point, especially as inventories are cut. Yet, the key is the extent to which it will recover to anywhere near past levels. Surely Japan will be ready when the world is about to take off again but there is a lot to suggest that the margins on export led growth will be a lot thinner than they are now since everybody seems to be in the midst of a transition towards the same growth strategy. In this light it seems as if Japanese manufactures may indeed be tucking themselves in for a prolonged hibernation.

Evidence to suggest this came recently from the hands of Morgan Stanley analyst Takehiro Sato who had an excellent analysis looking forward to the upcoming Tankan survej of Japanese industry. The key is that companies are expected to revise down their capex and investment plans drastically. Moreover, the most recent print for industrial production in the form of the preliminary report for February indicates that industrial production in Japan contracted at an annual 38.4%. In light of this extraordinary decline, Bloomberg is running a piece with the overall point that because Japanese manufacturers have been so fast in adjusting down their inventories (getting rid of excess capacity) we will soon see a pick-up as inventories have been cleared. The logic of this argument is indisputable, but I think that the underlying point is misplaced for two principal reasons. For starters, the recovery argument only holds if in a standard cyclical downturn and since the current debacle is clearly different I am weary about applying any kind of conventional wisdom here. Obviously, if inventories go to zero we get that famous "second derivative effect" noted above, but the overall level of growth and increase in production is likely to be very low if not negative. We should Remember that there is indeed a flipside to all these horrendous numbers coming in now and this is what level we will end on and how long it will take for us to get back up.

Finally and just to show that the crisis has had a notable effect in the market too just watch the absolute horrible performance of the main Nikkei index.

I am no equity analyst so I shall not belabour this point a lot, but merely note my personal inclination to disregard Japan in terms of the global market portfolio (beta) and in stead going for some alpha through stock picking which is obviously possible even if the overall trend is inexorably down. Go for the ones with exposure outside Japan is my advice, but that should be taken with a couple of truck loads of salt and I am ready to stand corrected any time by those much smarter than me in terms of trading equities.

The External Sector, Wither Growth

Perhaps one of the most interesting news points to come out of Japan since we last convened was the news that Japan had entered a current account deficit for the first time in a long while. This is significant for a number of reasons. First of all, it shows us the extent of the slump in that the trade balance balance has swung so fast and so much into negative territory. However, as I have argued endlessly we also need to look at income and here Japanese savers have been extraordinarily well endowed. Thus I also think that there is a technical issue to deal with here in that the income balance is likely to have swung into negative on the basis of the appreciation of the JPY we have observed in the latter part of 2008 and into the first months of 2009.

The CA deficit is not visible on the graph above but it does not take much imagination to see where the lines are going; especially not since we recently learned that Japanese exports dropped a whopping 49% year on year in February as shipments to the rest of world almost stalled completely.

Needless to say, the move of Japan's current account into deficit territory has sparked all kinds of interesting points not least in the context of Japan's impending forced rebalancing. It comes to no surprise to me that the Economist was the first to jump the gun hailing Japan's rebalancing act.

Japanese households used to be among the world’s biggest savers and, as a result, the country ran a massive trade surplus. But no longer. They now save less of their income than American households, and Japan’s trade balance moved into deficit last year (see top chart). A long-overdue—and painful—economic rebalancing is under way.

To be fair to the Economist, they do make the important qualifier that since the external balance is coming due to a collapse in external conditions rather than a shift in actual growth path it may not be exactly what the doctor ordered. Yet, the Economist also applies standard life cycle theory to suggest that as Japan grows older so will we start to observe dissaving on aggregate and thus predicts, like all those famous economic steady state models, that Japan according to theory should be running a current account deficit. I think this is way to simple and in order to move forward on this field some important adjustments need to be made to Modigliani's life cycle hypothesis and, crucially, how it applies to aggregate economies. A lot of the confusion arises in the context of Japanese households their low savings rate and the fact that Japan exactly seems to suffering from a dearth in consumption (domestic demand) and surplus of savings. In a recent piece by the New York Times this view is articulated pointing towards the obvious effect that when you have no domestic demand of any meaningful proportion you become de-facto dependent on external demand. However, Stefan Karlsson retorts that low consumer spending in Japan is the result of low growth and not the cause pointing to the historically low household savings rate in Japan.

The plot thickens and at this point we simply need to get some data on the table to see what is actually going on. As a first stab let direct the attention to three crucial issues when applying individual life cycle theory to aggregate outcomes. First, you need to distinguish between working and non-working households as the savings dynamics are bound to differ markedly. Moreover, you need to incorporate some kind of uncertainty buffer to adjust for the fact that the transversality condition does not hold and thus that consumers do not dissave to 0. Secondly, you need to look at the overall stock of savings as well as the flow to increase or decrease this stock. This is very important relative to the measure of the saving rate out of disposable income. Thirdly and intimately related to point two you need to look at the evolution of income and the change in the stock of saving relative to the change in income. With these points in mind, let us consult the data.

The first graph shows the evolution of annual income and the stock of savings and it represents an important picture since it shows us that Japanese households are indeed sitting on a large pile of savings measured as a stock even if as Scott Peterson showed us recently it is dwindling which indeed constitutes a worrying trend. The key point is of course what to do with those savings. Sure, one can spend them and dissave which is what would happen in a closed economy, but in an open economy the dynamics are likely to be strikingly different. Basically, this stock of savings represents a structural excess of savings on a stock basis and one of the only ways to make it count is to transfer it into income by investing abroad or by investing in export oriented domestic industries [1]. This is the only way that this saving can be transferred into investment and then into income. Consequently, Japan does suffer from a a chronic lack of domestic demand and consumption and it does so exactly because relying on consumption with the current demographic profile is not viable. Persons dissave, but societies do not since they don't have an end point or at least, a market economy has every interest in fighting off dissaving through the leakage of exporting excess saving. In this way, all the opinions introduced above get it wrong I feel because you really need to incorporate realistic assumptions on demographics. Take Mr. Karlsson's suggestion that Japanese households save more? Out of what I ask and assuming that these savings should be accumulated to invest later where would you invest it? At home (to what return) or abroad? This is exactly the key point since moving towards the NYT and their implicit narrative that Japan raises consumption the simple question is that she can't and understanding precisely why this is and what this means for the global economy is absolutely crucial. I shall spare no chance in pointing out this again and again.

Thus, if Japan wants growth it needs to make those savings count and oh boy have those Japs made it count.

In order to understand the graphs above you need to go back to James Hamilton's post about the paradox of thrift and in particular the simple representation of savings in an open economy. We consequently have;

Y = C + I + G + X and by definition net national savings defined as Y - C - G = I + X where X is the CA balance. [2]

Japan clearly has had, as the Economist rightly points to, a consistent surplus almost since 1980, but you need to read the fine print here. I am not saying anything about export orientation as such but more so about export dependency. In this way, let us run the following thought experiment and assume that all the talk in the 1980s about Japan unfairly sustaining a bilateral surplus towards the US represents a deliberate export oriented policy.

Now, why is this plausible? Well, look at the graph for investment as a share of GNI and witness how it actually rose towards the end of the 1980s and peaked with the bubble 1989-1991. Clearly, Japan got a strong accumulated boost from external demand throughout the 1980s which helped keep national savings high even though domestic investment rates fell. But was Japan dependent on this in terms of creating growth? This seems dubious in that investment rose sharply during the end of the 1980s and thus we can say that, all things equal, Japan had the the domestic conditions to create a sound investment boom/bust bubble.

But then we enter famous lost decade of Japan and whether be it for standard life cycle reasons or because of inept policies Japan never really managed to irk out an increase in domestic investment rates. Yet, if we add the accumulated surplus of domestic investment over domestic savings which by definition leaves the country as a leakage we get the CA surplus which despite secular declining domestic investment rates have risen. To put it more categorically, Japan has been able to save more than would have been merited by domestic capacity to absorb these savings through investment if we had a closed system.

So, and to make the final point on this. What I not saying is that this process is driven entirely and exclusively by demographics. Evidently it is not. What I am saying however is that at some along the way Japan becomes dependent on this process and thus that the mechanism by which the two is connected, that is the de-facto dependence of external demand and the existence of persistent external surpluses, need to be explored. One way to initiate this exploration is exactly to incorporate a strong demographi anchor in your macroeconomic analysis and then to realize that Japan is able to make up for the secular decline in domestic investment as predicted by life cycle theories by accumulating excess savings towards the rest of the world. In fact, given the situation with respect to consumption (C) where the base simply shrinks by the year and government spending (G) which is constrained in a number of ways the addition of growth from the CA surplus is crucial and when it dissipates as we are seeing now the edifice crumbles almost entirely.

Policy responses, stretched beyond the limit?

If you have made it this far, you will have gotten the impression that things look dire in Japan with regards economic growth, momentum as well as the outlook. However and just as the politicians in other parts of the world are digging deep in their toolboxes in order to find a remedy to the debacle, so are Japanese policy makers hard at work. Well, perhaps this is a bit exaggerated since if you are looking for extraordinary and new measures you should not be looking to Japan where both fiscal and monetary policy are following the path seen in the US, the UK, and Europe the latter in which monetary policy is lagging somewhat. So is it working?

We don't know yet, but one question which seems pressing at the moment is indeed what Japan will do as the conventional tools look fall desperately short of fixing the thoroughly broken economy.

This may be a rather hasty conclusion though. Consider for example the actions taken by the BOJ which almost makes the corresponding actions taken in the US and the UK look timid. The situation for the BOJ is a bit different than over at Kaiserstrasse, DC as well as in Treadneedle street since rates were already running very close to the zero bound when the crisis hit. In this way, one method that has been used extensively is the rapid expansion of the BOJ's balance sheet through the purchase of different categories of risky assets. This strategy seem to constitute a three pronged assault. The first attack was the announcement that the BOJ would be buyers of corporate debt (of highest A1 rating) in order to push down the lingering wide spread between the benchmark rate and the rate on A1 corporate paper. This makes sense in Japan since many companies choose to finance themselves through the FI market. Recently, Deputy Governor Hirohide Yamaguchi noted that the BOJ might have to increase its purchase of corporate to fight off what has been deemed to be extremely difficult financing conditions for Japanese companies.

Recently we got the second line of defense with the announcement that the BOJ would also be buyers of companies' subordinated debt. So far the move is only meant capitalise commercial banks where the BOJ may be pencilling in as much as a 1000 billion Yen worth of purchasing of subordinated corporate debt. On the technical side many analysts have argued that since these purchases would only boost tier two capital holding it might not address the issue at hand. Add to this that since these loans by definition could only be extended to the biggest of the commercial players small and medium sized actors would not benefit from these loans.

Finally there is the third line of defense which simply involves the BOJ moving into equities and if the debt market is a murky area then the equity market must be pitch black from the point of view of the BOJ. So far, the official purchases of equities have been suggested through different vehicles such as for example the Development Bank of Japan. Yet the time may be nearing when the BOJ has to move in to support the market in general and in this case things of course start to get decidedly messy. What kind of companies to invest in? Should the BOJ hold the market or go for "stock picking"? etc. Yet, it may seem to a prudent move all together since as Glenn Maguire, chief Asia economist at Societe Generale is quoted of saying in the FT;

“Japan’s toxic assets are essentially equities and any pick up in stock markets will be more significant for improving tier one capital,”

Given the same Hirohide Yamaguchi's recent comments that the BOJ is seriously contemplating a move back into ZIRP, it looks as if we will soon see yet another step in the central bank's fight against the crisis.

Moving on to fiscal policy it seems, and unfortunately so, that most of the recent messages from Japanese politicians are merely gloss to prepare for the upcoming elections. In this way, prime minister Aso's recent chant that Japan must ready a third stimulus package is not greeted well by observers. And then we need to add the lingering issue of Japan's already elevated, and wholly unsustainable, debt level.

Consider consequently the very valid point that the BOJ could like the Fed and the BOE move in to aggressively buy up government bonds to a higher degree than is currently the case. As such Deputy Governor Hirohide Yamaguchi has noted that increased central bank funding for the MOF might actually increase yields as investors weighed the risk concerning the public debt against the decision. Circumstantial evidence is already mounting that as the Japanese government readies one stimulus package after the other yields are reacting adversely to the interest of the MOF as issuer. Takehiro Sato pinpoints the situation well when he says;

The ultimate dilemma for the government/BoJ is that, while a half-hearted fiscal expansion may fail to overcome the downward spiral of the economy, an overblown version risks depressing market confidence in the fiscal policy.

Finally, and as Scott Peterson eloquently points out you also need to look at where the money is spent (and on what) since Japan really needs to get as much, as it were, bang for the buck.

No Way out for Japan?

I can understand if my readers and in particular those of you who have made it this far are a bit annoyed at this point. Here I go again with the doom and gloom about Japan. Well, true as this may be, let me just reiterate the main point so obviously present in the data that Japan is in an absolutely horrendous situation in economic terms. However, this does not mean that I should not be focusing on solutions. Don't worry, I am getting there, but I also want it to come out right so I am holding off my guns a bit.

Meanwhile, in this note I have attempted to hammer down some more theoretical arguments using long term data and thus a more comprehensive argument. As for the immediate economic outlook it is not particularly good. All main gauges point downwards and it is almost certain that Japan will be facing deflation in the coming quarters (if not years). This will intensify the credit crunch and further bring into doubt the sustainability of the Japanese public debt situation. This is a well known narrative, but it is important since it seriously cripples policy makers in their attempts to actually do something. On the back of this, the real sector is suffering. Most notably industrial production has stalled completely faced with the dramatic slowdown in external demand and coupled with the inability of domestic demand to take up the slack in any given sense of the word Japan is simply being pulled down by the full weight of its inability to mount a challenge towards the headwinds blowing from the global economic crisis. I call it engine failure because it is in fact what it is, a failure of the well lubricated export engine that has, when active, driven the Japanese economy in the past decade. Once again I will finish with the almost trivial point in the context of Alpha Sources' musings that this has to do with demographics and the age structure of Japanese society. The sooner all parties involved understand this, the sooner we can roll up our sleeves and get to work on solutions.

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[1] - the observed decline in home bias among Japanese investors is an important part of the picture here.

[2] - Readers with basic mathematical inclination will notice that expressing the spread between investment and net exports and foreign asset income as the addition to national savings from external demand, is just a detour of expressing the current account balance as a share of GNI. Thus basic algebra gives;

I/GNI - I+(X-M)/GNI = [I - I + (X-M)]/GNI; (cancelling out the I's) gives (X-M)/GNI.

Japan's Industry Reels Under The Slump In World Trade

Japan's economy certainly looks to be one of the worst case scenarios globally at the moment. Indeed, as Claus Vistesen puts it (in a very fine and thoroughly argued post - Engine Failure - that you can see here): "Final estimates from Q4 2008 suggested that Japan contracted at an annualized 12.1% which puts Japan in the dubious pole position of biggest GDP declines among industrialised economies."

This record breaking negative performance seems in danger, not only of being repeated, but even of being surpassed, in the current quarter, since Japanese industrial output slid for the fifth month in a row in February as falling exports gradually took their toll on the entire conomy, with production being down 38.4% year on year.

The seasonally adjusted Nomura/JMMA Japanese Manufacturing PMI (Purchasing Managers' Index) remained deeply entrenched in negative territory in March, posting a reading of 33.8. Up on February, but still well, well below the 50 contraction boundary reading. Despite rising for the second straight month, the headline index still signalled the fourth-sharpest deterioration in operating conditions recorded by the series to date.



In what should be seen as a very real and immediate warning survey respondents signalled that domestic demand and the employment outlook had deteriorated as clients postponed investment expenditure given the bleak economic outlook. Data also pointed to a sharp drop in new work received from abroad. This seems to imply that we will now get an ongoing series of "second round" effects, as investment is postponed, and consumers hang on to their money just in case they are not able to hang onto their job.

In another warning signal, average cost burdens declined at the fastest rate in just over seven years in March. Survey responses frequently linked the latest drop to lower prices for a wide range of raw materials amid low demand in global markets. March marked the fourth month running in which input prices have decreased. Japanese prices already seem to be well back in deflation territory.

So, despite the fact that Japanese Finance Minister Kaoru Yosano said last Friday that February's fall in the so called "core-core" consumer price index doesn't mean Japan is back in deflation, few are ready to accept his judgement. Indeed, if you look at the core-core line in the chart below, it is at least debateable whether the Japanese economy was ever out of it in the first place. But the present debate has really been set of by data that was released on Friday which showed a 0.1% on-year fall in the core-core index (that is the basic index with food and energy stripped out), while the core consumer price index (which only excludes food) was flat from a year earlier.


The average index reading over the quarter dropped from 36.6 in Q4 2008 to 31.7 in Q1 2009. It is hard to put a precise GDP number on what this means, but plunging global demand - the World Trade Organization said last week that global commerce may well shrink 9 percent this year - and weak consumption at home, may well mean Japan’s economy shrinking by anything between 3% and 4% per cent in the first quarter, extending the run of contraction to four quarters in a row.

Export Slump

Japan’s exports plunged a record 49.4 percent in February as deepening recessions elsewhere hit demand for Japanese products. Shipments to the U.S., which is still Japan’s biggest market, tumbled an unprecedented 58.4 percent from a year earlier, with automobile exports down a horrific 70.9 percent.



It is clear that Japanese companies cut inventories at an unprecedented pace in February so we may well now see some sort of increase in production in coming months.Inventories fell 4.2 percent, the biggest decrease since record-keeping began in 1953.

“The sharp adjustments in production and inventories are probably finished,”
said Sugiura, chief economist at Mizuho Research Institute in Tokyo. “But we
don’t expect a sharp rebound in production because exports are dropping very
significantly.”

This second monthly reduction means that Japan's inventories are now at their lowest level since August 2007. Asa result manufacturers forecast they would raise output 2.9 percent in March and 3.1 percent in April - but this is not what the March PMI shows, rather there is a continuing contraction, but at a slower pace as there are not so many inventories to run down now. Toyota now expects to have adjusted inventories to levels that reflect demand by April, according to its President Katsuaki Watanabe. Toyota cut global output a record 53 percent in February and led the 56 percent decline in Japan’s domestic vehicle production, the biggest drop since at least 1967.

Japan’s 12 car manufacturers produced 481,396 vehicles (according to the Japan Automobile Manufacturers Association), while car exports dropped 64 percent to 212,107 vehicles, with North American shipments falling 66 percent. As well as Toyota, Nissan, Mazda and Mitsubishi Motors all cut domestic production by at least 60 percent last month to trim inventory. Japan’s domestic car production has now posted record drops every month since November.

A critical decision

Bloomberg has a piece out describing the debate in Japan over the Aso government's plans for a new spending package, noting that "Japan’s 17-month recession is showing no signs of abating, and Aso may be tempted to attract rural voters with the pork-barrel projects that left the country with the world’s largest public debt." The Bloomberg piece adds that "some ruling Liberal Democratic Party lawmakers, led by former Finance Minister Koji Omi, this month urged Aso to spend 14.7 trillion yen, mainly on improving rural roads, airports and harbors and developing magnetic-levitation train lines."

This would be a terrible mistake.

Any infrastructure spending should be directed to the country's major metropolitan areas, where productivity would be increased by improved traffic flow. The last thing Japan needs is more infrastructure in rural areas, where population is shrinking more rapidly, and where vast sums have already been spent.

Bloomberg points out that "Japan invested trillions of yen in roads, bridges and buildings in the 1990s to rejuvenate the economy after the collapse of an asset-price bubble caused a decade-long slump. The spending failed to sustain growth, and gross domestic product only began expanding in consecutive quarters when exports recovered during the technology bubble of 2000." Most of this spending benefited rural areas and domestic construction companies. "The investments fueled the expansion of the construction industry, “which isn’t very productive,” said Ryutaro Kono, chief economist at BNP Paribas in Tokyo and also a member of the group that met with Aso. That may explain why Japan’s potential growth rate decreased since then, Kono said."

Exactly. Government spending should be directed toward projects that will result in increased productivity, as the country will need it as its aging population results in a major shrinkage of the workforce. Japan's political and economic system has been based on subsidizing rural areas and the export sector at the expense of the working populations concentrated in major metro areas. This needs to change for the country to return to long term economic health.

Japan - The Lost Quarter Century

Despite the fact that Japanese Finance Minister Kaoru Yosano said Friday that February's fall in the so called "core-core" consumer price index doesn't mean Japan is back in deflation, few are ready to accept his judgement. Indeed, if you look at the core-core line in the chart below, it is at least debateable whether the Japanese economy was ever out of it in the first place. But the present debate has really been set of by data that was released on Friday which showed a 0.1% on-year fall in the core-core index (that is the basic index with food and energy stripped out), while the core consumer price index (which only excludes food) was flat from a year earlier.



The preoccupying inflation news came on the same day we learnt that retail sales had retreated in February by the biggest margin in seven years, as growing concerns about jobs and wages had an obvious impact on Japanese shopping habits. Retail sales were down 5.8 percent from a year earlier (to 9.98 billion yen) — the sharpest decline since February 2002. The figure marks the sixth straight month that sales have fallen at retail outlets like department stores and supermarkets.

Business at department stores, which tends to reflect spending on luxury goods and premium items, was especially bleak in February, with sales down 11.5 percent from a year earlier.



And the reason why prices are falling, and workers are fearful for their jobs? Well just look at the export numbers: Japan’s exports plunged a record 49.4 percent in February as deepening recessions elsewhere hit demand for Japanese products. Shipments to the U.S., which is still Japan’s biggest market, tumbled an unprecedented 58.4 percent from a year earlier, with automobile exports down a horrific 70.9 percent.





So the massive contraction in industrial output that this decline in export business is producing is sending shock waves through the economy, and it is the pressure from all the excess capacity that this is generating that is now forcing prices downwards. Nowhere is the process clearer in land and property values, long the key driver of the deflation process in Japan - and we learnt only this week that Japanese residential land prices fell 3.2 percent to a 24-year low last year, their lowest level since 1984. Overall property prices declined 3.5 percent, wiping out completely the recent two years of gain that followed the earlier 15-year slump.

And the decline in residential land values, which are about half of what they were at the height of the bubble in 1991, only looks set to continue as the recession deepens. So in property market terms at least, it isn't the lost decade anymore, we're now moving into the "lost quarter century".

Japanese savings shrink

The Nippon Keizai Shimbun is reporting today that

"Japanese household financial assets totaled 1,433.5 trillion yen at the end of December, falling 5.7% on the year to a 4-year low, the Bank of Japan's preliminary data released Tuesday showed. This is the sharpest annual drop on record.

Slumping stock and investment trust prices took a toll on household assets. Stock holdings plunged 40.2% on the year to 87.8 trillion yen, while investment trust beneficiary receipts decreased 33.4% to 47.9 trillion yen.

In contrast, as Japanese sought to stash money in safer places, cash bank deposits inched up 0.9% to 791.6 trillion yen, 455.1 trillion yen of which were in time deposits, up 2.5%."

The highlighting is mine...this is not good news for a country where a large proportion of the population is expecting to live off of savings fairly shortly. Further, Japanese consumers are unlikely to provide a boost to GDP as they are not going to increase discretionary spending in the face of investment losses.

Summary of Japan's economic situation

A commenter provided a link to Japan in trouble; India relatively safe, a piece in The Economic Times which states:

"Some foresee Japan--one of the world’s biggest exporters--going bankrupt and its currency plummet if the situation doesn’t change near term.

For years, the Japanese have relied on exports to support their economy... but exports have dried up given the severe recession in the global economy, especially in the US. In the last six months, Japan has lost almost a quarter of a trillion dollars in export revenue.

In January, Japan's exports plunged nearly 47% leading to a trade deficit of $9 billion. This is Japan's first trade deficit in 13 years and its biggest deficit in 25 years.

“When you consider the debt, the bad economy, and the coming population problem, it's clear the Japanese government will go bankrupt and may not pay off the money it owes,” said Jonathan Paul, principal economist at Krug and Bordman Advisory.

“There is a much smaller workforce (in Japan) which actually pays taxes. The economy has shrunk and hence businesses are also paying less tax. Second, the elderly consume social security, health care, and pension resources. These are costs to the government. As the senior population rises, these liabilities increase. The elderly don't pay income taxes,” Paul added.

Japan has the second-lowest birth rate in the industrialized world. In Japan, the birth rate has fallen below 1.2. Japan's population fell for the first year in 2005. By 2050, if this trend continues, Japan's population will fall by 20%.

The other problem is life expectancy is going up in Japan. So the elderly are becoming the largest segment of Japan's population. Right now, 20% of Japan's population is over 65 years. By 2050, 40% of Japan's population will be over 65 years old. In the US, the “65 and up” population makes up about 12% of society.

Since falling into a recession 20 years ago following the Asian economic crisis, the Japanese government has infused trillions of dollars into its banking system. In the last six months, it approved three stimulus plans totalling $100 billion. This week, the Japanese prime minister proposed the largest bailout plan yet of $200 billion. As a result, Japan now owes its creditors $7.8 trillion.

Going by the government debt to GDP, a measure for indebtedness of a county, Japan leads with a ratio of 187 per cent. The US follows with debt-to-GDP ratio of 75 per cent, and UK at 48 per cent. "

Now a significant amount of the country's debt is held by it's own citizens, but that is still a claim on the country's future GDP, which will have to be produced by a significantly smaller population.

Effect of US government debt monetization on Japan

The yen has strengthened versus the dollar significantly in the short period since the US Federal Reserve announced that

"the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months."

The higher yen will continue to harm Japanese exporters repatriating profits from the US and of course hinder the ability of these companies to adjust prices to make up for the reduced amount of yen realized from each dollar of profit. I expect that Japan will be experiencing at least periodic trade deficits in the near term.

Possible inflection point?

Bloomberg has a report headlined Japan’s Funding Crunch Deepening with the key item being that

"The funding crunch for Japanese businesses is intensifying as foreign-currency financing dries up, forcing larger firms to turn to the nation’s state policy bank for emergency loans, the head of the lender said...JBIC, which provides funds to help bolster Japanese companies’ international competitiveness, plans to make emergency loans in cooperation with domestic banks at bank market rates...The bank will receive $5 billion in foreign currency reserves from the government this month to lend to companies as even the largest firms face difficulties getting dollars. The bank may seek additional reserves from the government as JBIC itself faces higher costs for selling foreign-currency bonds."

The government is planning to use some of its foreign currency reserves! Now this is a relatively small amount compared to the government's total holdings, but it might be the start of a long term decrease. If Toyota, which is one of the companies to be included in the program, can't get dollar financing at terms it thinks reasonable, then the rest of the country's industrial sector will be having problems. Given that Japan ran a current account deficit in January, its use of dollar reserves will be something to keep an eye on.

Update on QE in Japan

By Claus Vistesen: Copenhagen

Quantitative easing is certainly all the rage at the moment after this week saw the Bank of England move interest rates down 50 basis points to the level of 0.5% and, effectively, into QE. Over at Morgan Stanley, Manoj Pradhan talks about a new global QE scheme even if we are not quite there yet, and David K. Miles and Melanie Baker talk about the UK version. In the Eurozone, it appears that something fundamental has happened at the ECB with this week's decision to lower interest rates from 2% to 1.5%. At least, our good governor Trichet now seems to concur that the risks of inflation have receded (for now) and that a subsequent risk of deflation is present. This also means that me and Edward's stab at the ECB earlier might have been a bit unfair although I see the communications stream from the ECB is still quite volatile. Consequently, council members Jürgen Stark and Lorenzo Bini Smaghi were both quoted of saying that one should be weary of cutting interest rates too much since the impact of such measures would be limited. One wonders whether it is the blind leading the deaf or the other way around, and quite frankly I would, at this point, settle for a coherent message from the ECB, be it in favor of QE measures or not.

Meanwhile and on a brighter note, Cassandra approaches QE from a slightly more semantic and, as it were, historical perspective.

And in Japan ...

In Japan QE has arguably been in play since November 2008 or perhaps as some would smugly note; Japan never came off the tap having only been able to raise rates to 0.5% during this famed and so-called recovery which abruptly ended little less than a year ago. Whichever the version you prefer it appears that the BOJ will have to step up its efforts in the market for risky assets. The news is attached to Deputy Governor Hirohide Yamaguchi's comments that the BOJ have to increase its purchases of corporate bonds to alleviate the credit crunch.

Bank of Japan Deputy Governor Hirohide Yamaguchi said the central bank may need to expand its purchases of corporate debt to prevent a credit shortage from worsening the recession. “We can’t deny corporate financing will become even more difficult” toward the fiscal year end on March 31, Yamaguchi said in an interview in Tokyo yesterday, his first since joining the board in October. “If that happens, we’ll consider whether we can enhance operations already implemented and act if necessary.”

Yamaguchi is the first member of the board to hint at further policy actions since it unveiled the plan to purchase corporate bonds from banks last month. Having cut interest rates close to zero, the central bank is buying assets to channel funds to businesses whose profits are falling the most in more than 30 years as demand dries up at home and abroad.

The problem is of course a well known one; on the one side big companies are finding it difficult to raise capital (through equity as well as debt) and for small companies the credit crunch is ever present as their credit lines and facilities with banks are getting squeezed. In terms of the former, Bloomberg reports that three of Japan's biggest automakers Toyota, Mazda, and Honda publicly stated last week that they might need government funds as demand for their products have collapsed. Especially, the mounting problems for Toyota are preoccupying as it is bound to send ripple effects through its big network of suppliers As for the latter in the form of small businesses the current credit crunch marks a multi decade low point for financing condition.

SFCG Co., a bank focused on lending to small businesses, collapsed last month in Japan’s biggest bankruptcy by a publicly traded company in almost seven years. Chairman Kenshin Ohshima said getting funding had become “almost impossible.”

Small companies, which employ about 70 percent of the workforce, said access to finance is the harshest it’s been in at least 23 years, according to a survey published by Shoko Chukin Bank last month.

As I noted in my last entry on Japan and as Bloomberg elaborates one way in which the problem is being handled is for the BOJ to engage in direct purchases of corporate debt (A1 rating). At the time the BOJ committed itself to the purchase of 33 trillion Yen worth of corporate debt alone in Q1 2009. The immediate goal for the BOJ is however not narrated as re-capitalisation per se, but merely to narrow the widening spreads between government bonds and class A corporate paper. Apart from buying corporate paper the BOJ has naturally also been involved in the purchase of government paper to ease the funding requirements of the government in its effort to use fiscal stimulus as a tool to alleviate the crisis. The comments from Yamaguchi in this regard are interesting;

When asked whether the bank would increase the purchases to fund economic stimulus spending, Yamaguchi said buying bonds for that reason would spur concern that public debt will rise, driving yields higher and compounding Japan’s fiscal woes.

This is of course the eternal headache faced by Japanese policy makers in their attempt to use the fiscal weapon since the simple point is that they don't have the money or the future revenues to mount anything remotely resembling a credible fiscal jolt. As an alternative the Finance Minsitry has been working with the idea to capitalise (well, cover the potential losses) and subsequently allow the Development Bank of Japan to enter the market for equities and preferred shares in order to prevent a wave of corporate bankruptcies.

Of course, the problem for the MOF lingers if anything simply because they will have to issue a considerably amount of IOUs in the coming months and quarters. As one could imagine, markets have not been oblivious to this trend.

Japanese 10-year bonds completed the biggest weekly decline in a month on speculation that governments in the U.S., Japan and Europe will increase spending to help counter a deepening recession. Benchmark yields held near the highest level in four weeks after Chief Cabinet Secretary Takeo Kawamura said the government needs to make the “utmost effort” to manage policies to prevent stocks from collapsing, spurring concerns that the nation’s debt burden will worsen. Sales of government bonds will rise to 113.3 trillion yen ($1.2 trillion) in the year starting April 1 from 106.3 trillion yen this financial year, the Ministry of Finance said in December.

“Given the severe state of the Japanese economy, the government may need to boost budget spending by an additional 15 to 20 trillion yen,” said Hirokata Kusaba, a senior economist in Tokyo at Mizuho Research Institute Ltd., a unit of Japan’s second-largest bank. “The issuance of new bonds may increase by 30 trillion yen, boding ill for the debt market.”

It is interesting to note the opposing trends here. One the one hand yields should be coming down to reflect the fact that interest rates are about to go lower, but since interest rates are virtually zero it is not at all unimaginable that yields will go up to reflect the increased supply of bonds in the market (and the general public debt situation in Japan). It is of course because of this that the MOF needs the BOJ and one would be tempted to argue other domestic cash rich investors to buy the debt. At this point I would not point to a heightened concern for the government's financing possibilities if anything because the game of issuing IOUs is turning global. Yet, it should be watched as we move forward.